Types of Cash Flow

You’d think a cash flow statement would be easy to read. Since cash is real money, there are no assumptions and estimates incorporated in the numbers. Cash coming in is a positive number, cash going out is a negative one, and net cash is simply the sum of the two. In fact, though, we find that nearly every nonfinancial manager takes a while to understand a cash flow statement. One reason is that it is always divided into categories, and the labels on the categories can be confusing. A second reason is that the positives and the negatives aren’t always clear. (A typical line item might say, “(increase)/decrease in accounts receivable”, followed by a positive or negative number. Is it an increase or a decrease?) A final reason is that it can be tough to see the relationship between the cash flow statement and the other two financial statements.

I’ll take up the last issue in the following lesson. Right now, let’s just sit down with a cash flow statement and learn the basic vocabulary.

Types of Cash Flow

The statement shows the cash moving into a business, called the inflows, and the cash moving out of a business, called the outflows. These are divided into three main categories.

Cash From or Used in Operating Activities

At times you’ll see slight variations to this language, such as “cash provided by or used for operating activities”. Whatever the specifics, all of this is more accountant-speak: too many accountants can’t say, “operations”, they have to say, “operating activities”. But whatever the exact language, this category includes all the cash flow, in and out, that is related to the actual operations of the business. It includes the cash customers send in when they pay their bills. It includes the cash the company pays out in salaries, to vendors, and to the landlord, along with all the other cash it must spend to keep the doors open and the business operating.

Cash From or Used in Investing Activities

Note that investing activities here refers to investments made by the company, not by its owners. The biggest subcategory here is cash spent on capital investments – that is, the purchase of assets. If the company buys a truck or a machine, the cash it pays out shows up on this part of the statement. Conversely, if the company sells a truck or a machine (or any other asset), the cash it receives shows up here.

Cash From or Used in Financing Activities

Financing refers to borrowing and paying back loans, on the one hand, and transactions between a company and its shareholders on the other. So, if a company receives a loan, the proceeds show up in this category. If a company gets an equity investment from a shareholder, that too shows up here. Should the company pay off the principal on a loan, buy back its own stock, or pay a dividend to its shareholders, those expenditures of cash also would appear in this category.

You can see right away that there is a lot of useful information in the cash flow statement. The first category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. A company with a consistently healthy operating cash flow is probably profitable, and it is probably doing a good job of turning its profits into cash. A healthy operating cash flow, moreover, means that it can finance more of its growth internally, without either borrowing or selling more stock.

The second category shows how much cash the company is spending on investments in its future. If the number is low, relative to the size of the company, it may not be investing much at all; management may be treating the business as a “cash cow”, milking it for the cash it can generate while not investing in future growth. If the number is high, relatively, it may suggest that management has high hopes for the future of the company. Of course, what counts as high or low will depend on the type of company it is. A service company, for instance, typically invests less in assets than a manufacturing company. So, your analysis has to reflect the big picture of the company you’re assessing.

The third category shows to what extent the company is dependent on outside financing. Look at this category over time, and you can see whether the company is a net borrower (borrowing more than it is paying off). You can also see whether it has been selling new shares to outside investors or buying back its own stock.

Finally, the cash flow statement allows you to calculate Warren Buffett’s famous “owner earnings” metric.

Wall Street in recent years has been focusing more and more on the cash flow statement. As Warren Buffett knows, there is much less room for manipulation of the numbers on this statement than on the others. To be sure, “less room” doesn’t mean “no room”. For example, if a company is trying to show good cash flow in a particular quarter, it may delay paying vendors or employee bonuses until the next quarter. Unless a company delays payments over and over, however – and eventually, vendors who don’t get paid will stop providing goods and services – the effects are significant only in the short term.